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Modi must address India's fiscal divide

New Delhi needs to allay suspicions over tax revenue redistribution

| India

A political storm is brewing in India over proposals to change how collected taxes are divvied up among the national government and the country's 29 states.

Southern states are up in arms about possible changes that would see their revenue share decline. These states are relatively wealthier than their northern counterparts, so their residents already pay more in taxes.

Cultural and political differences factor in the tensions. Many of the southern states are ruled by parties in political opposition to Prime Minister Narendra Modi and some see maneuvering ahead of national elections due next year underlying his administration's revenue-sharing proposals.

The southern states are against moves they see as rewarding northern peers' failure to make as much progress in social and economic development. Other states are unhappy too about suggestions the national government wants to hold onto a greater share of the revenue pool for itself.

The Modi administration should move quickly to defuse these disputes. The review of revenue-sharing formulas is carried out every five years and normally quite routine.

State finances have already been hit by the introduction last year of a national goods and services tax that superseded a web of state levies. New Delhi must recognize that the states cannot absorb further broad cuts to their revenues.

At the same time, New Delhi must respond to the southern states' objections to make the case for common sense tweaks to the formulas for divvying up tax revenues. The southerners' arguments about rewarding socio-economic progress have merit, but can be addressed in other ways.

As in the past, the revenue-sharing formulas are being reviewed by a specially appointed Finance Commission. Part of the controversy this time stems from an instruction by the Modi government that the new commission reconsider a decision by its predecessor that raised the share of the tax pool allocated to the states from 32% to 42%.

Such a reversal could cause serious fiscal problems as most states are currently running annual budget deficits. The Indian constitution gives the bulk of taxation powers to the federal government but assigns states responsibility for most public services.

The Modi government has also instructed the Finance Commission to review whether to end special grants used to cover gaps between states' income and spending. These grants will help to compensate for the national government's increasing reliance on surcharges and special-purpose levies that are excluded from the revenue-sharing pool.

The previous Finance Commission recommended that 1.94 trillion rupees ($28.5 billion) be provided in revenue-deficit grants to 11 states over the five fiscal years to March 2021, based on their spending requirements and difficulty generating revenue themselves.

The administration says the abolition of revenue-deficit grants would encourage budget discipline, but the reality is that it would seriously increase the pain of changes in the distribution of revenues and potentially force states to curtail spending on basic public services such as health and sanitation. By the same token, the overall share of the tax pool going to the states should remain at 42%, providing some stability in income levels and flexibility for states to devise policies and programs suited to their local realities.

The north-south revenue controversy stems from what would at first appear to be a technical point. The Modi government has instructed the Finance Commission to use the 2011 national census, the country's most recent, as the basis for revenue-sharing calculations, rather than the 1971 census used in previous years.

The use of up-to-date population numbers is logical but controversial because of slower population growth in southern states. The total share of India's populace living in the five relatively wealthy states of Andhra Pradesh, Telangana, Karnataka, Kerala and Tamil Nadu fell 4 percentage points to 20.7% between 1971 and 2011 while the proportion living in the six poorer northern states of Bihar, Jharkhand, Madhya Pradesh, Chhattisgarh, Rajasthan and Uttar Pradesh rose by 4 percentage points to 42.7%.

To overcome southern protests, the Modi government must start by challenging the perception that it is penalizing the south for its impressive economic and social progress, including its success in reducing birth rates through women's education, health care and economic empowerment.

New Delhi should explain forcefully that the shift from the 1971 census baseline to the 2011 one is a fundamental requirement for a fair and coherent system of taxation and spending. The use of up-to-date census data is an essential acknowledgement of the reality of a changing population.

Shifting revenue from south to north should not be seen as a penalty for social and economic progress, but rather as the point of redistributive taxation. Poorer northern states need funding sufficient to cope with their increasing populations and to ensure the delivery of India's wider goal of providing a minimum level of public services for every citizen. This redistribution should help laggard northern states to catch up with their more developed counterparts.

Nevertheless, New Delhi should consider giving northern states financial incentives to address socio-economic conditions. The Finance Commission could make a portion of state tax transfers conditional on meeting specific targets on female fertility rates, births or infant mortality.

In general, there is a need for dialogue between the states and the national government to minimize distrust and assure states affected by revenue reallocation that their interests will be considered. Modi's government has not given much attention to this issue, which has contributed to a rise in friction with the states, further alienating the non-Hindi speaking south.

There is a further important reason why the revenue-sharing formula dispute should be settled amicably. Seats in the lower house of parliament are also allotted among the states based on the 1971 census. This has given the south greater representation than its current population merits. This arrangement is due to end in 2025. Agreement on the census issue now could help to avoid political turmoil in 2026 when seats will have to be reallocated.

Ritesh Kumar Singh is a corporate economist in Mumbai. He was assistant director of a previous Finance Commission of India.

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